Every investment has risks, limitations, and drawbacks that impact its appropriate level of asset allocation in each investor’s portfolio. It’s important to learn about these potential downsides for a couple reasons.
First, doing so helps you determine the appropriate weight for that investment within your portfolio. Second, learning about the downsides can sometimes give you an insight into ways they become upsides.
Full Cost Up Front
Real estate investors regularly rely on leverage to build their portfolio. Purchasing properties with just 20 to 30 percent down through commercial loans is the goal, allowing a bank to finance the rest.
As I’ve mentioned, mortgage loan investors, on the other hand, pay the full amount the loan is being sold for. There is no leverage in mortgage loan investment, meaning banks will not finance mortgage loans. This can mean that an investor’s funds don’t go as far—if an investor has $100,000 to invest, they might be able to buy four $100,000 rental homes, but only four $25,000 mortgage loans.
Leverage sounds like a pretty big advantage given to real estate investors, but it can get risky. In every loan transaction, the lender puts themselves in the best position to secure their capital. In other words, they will set themselves up to collect their money whether you can afford to keep paying or not. Banks require most investors to personally guarantee commercial loans, which means that if the borrower defaults, the lender can make a claim against the borrower’s, or in this case, investor’s personal assets.
Let’s say that after you buy a multi-unit building with bank financing, there is a severe economic downturn. Your tenants can’t afford to pay their rent because they are out of work. You’re collecting only 50 percent of the monthly income you expected and, frankly, depend on, and you’re unable to continue to meet the large mortgage payment and pay for repairs, insurance, utilities, and real estate taxes. You have burned through your cash reserves trying to keep the building afloat and now have to come up with extensive legal fees in order to evict tenants who cannot pay rent.
After a long eviction, you are faced with staggering expenses to rehab the units to get them ready to re-rent. Do you expect the bank to cut you some slack and allow you to not make loan payments for twenty-four months while you try to get back on your feet? Or how about asking them to loan you more money to pay the legal fees, fix up the units, and re-rent them? You might hope that, but they won’t do it.
Eventually, the lender will file foreclosure and seek a deficiency judgment against you personally, which would allow them to recover the amount you owe the bank from any personal assets you own. At this point, to save your personal assets, you will have few options other than filing bankruptcy.
In my experience, most real estate investors vastly overleverage and don’t maintain the massive reserves needed to survive an economic downturn. They want to put their cash to work as quickly as possible by purchasing more units. Unfortunately, too many real estate investors are financially destroyed during downturns and lose not only their credit, but also all the cash down payments they invested as well.
It’s just too risky for my appetite, and instead of holding on to huge cash reserves to offset the risks in real estate, I would rather place those in an investment that returns less volatile income.
This accelerated risk for real estate investors taking advantage of leverage is, in actuality, a downside. It means that mortgage loan investment’s lack of leverage is a benefit for the investor. Since we have paid cash for a loan, we know our maximum downside risk: the price of the loan. We needn’t worry about considerable additional expenses piling up on us when we can’t afford to pay them, or having those expenses jeopardize our ability to maintain ownership of our assets.
Depreciation and Tax Benefits
Taxes are a consideration for every investor. Real estate investors, in particular, have some tax advantages that those of us investing in mortgage loans do not get. Like many things, however, these advantages do have a darker side.
One of the most notable tax benefits enjoyed by real estate investors is depreciation. Certain investors, including those with rental property, can write off the loss of value that comes from wear and tear since this use depreciates the property over the years. Depreciation adds a great tax benefit to the bottom-line income of real estate investors, but there is a hitch.
The fact that depreciation is a write-off shows that the IRS knows rental properties break down quickly and require consistent, expensive repairs. That’s why the tax code gives such generous depreciation allowances, allowing investors to depreciate the building over a twenty-seven-and-a-half-year period (thirty-nine years for commercial properties). But that write-off ends even quicker when the property is sold. It’s at that point that the depreciated value is considered “recaptured” and is then taxed as ordinary income, with a current cap of 25 percent.[1]
Real estate investments made with IRA accounts cannot be depreciated and have a long list of restrictions and potential taxations (including UBIT) that you should review carefully with your IRA custodian and CPA. You may find that investing in rental properties in an IRA can actually result in you paying more in taxes.
Another potential problem is that we don’t know if and how these tax breaks will continue. Tax laws in the 1980s allowed for first-year depreciation of 11.7 percent. Today, first-year depreciation is capped at 3.63 percent. Who knows what the future brings for this and other aspects of real estate investment taxation?[2]
For these reasons, I am very comfortable guaranteeing you that taxes in the future will be higher than they are now, and the government may target tax breaks and incentives for real estate investors. If the tax breaks go away, what benefits will be left?
The problem with depreciation and loss is that for underwriting purposes, banks routinely only credit investors for 75 percent of their rental income. This helps them account for expenses related to vacancies and repairs. Unless an investor has huge cash flows or a huge W2 income, they run the risk of not being able to qualify for continued mortgages. In fact, the more units you have, the more likely it will appear to banks that you are operating at a loss.
Other tax benefits given to real estate investors include:
● cost of repairs
● maintenance and upkeep expenses
● property taxes
● management fees
● legal fees
● advertising costs
Sure, a deduction for all these expenses is helpful, but consider the fact that real estate investors have to keep the capital on hand to pay for all those expenses, whenever and however often they arise, and you can see how quickly the downsides of real estate investing outweigh the tax advantages.
As a mortgage loan investor, all I own, literally, are two signed documents that give me the ability to collect a set number of payments, and the right to a residential property as collateral. It’s well worth the trade-off because mortgage loan investing is a much more scalable business.